6/03/2005 @ 12:01AM

Real Estate Vulnerability Index

Housing prices have risen so far and so fast, who can afford to buy anymore?

Plenty of people. Of course, those people don’t live in New York. Or San Francisco. Or Miami.

As everyone knows (or should know by now), home prices have increased around the country over the last few years. In some places, they have shot up like wayward bottle rockets–and many people expect them to eventually come dropping down.

But prices alone can’t tell the whole story. To get a better picture of which cities are likely to be vulnerable to a real estate decline, with the help of Economy.com, we compared incomes to home prices, factoring in interest rates.

We were surprised at the results: While it has become much more difficult to buy the median house with the median income in many cities, in others it has actually become easier, pointing to a boom taking place in pockets, rather than the nation as a whole.

That backs up what many economists, including Federal Reserve Chairman Alan Greenspan, have opined–that some areas appear more “frothy” than others and could be primed for a bust–or, more likely, a slow decline, as real estate prices tend to stagnate rather than crash.

“I think low affordability does present a risk for markets,” says
Celia
Chen
Celia Chen
, director of housing economics at Economy.com, a research company based in West Chester, Pa. The firm supplied income, home price and affordability data going back to 1980 for 12 major metropolitan areas. “It’s a condition that can’t persist forever. If income streams are not sufficient to cover your housing costs, eventually demand is going to slow.”

Economy.com calculates affordability using incomes, sale prices for single-family homes and composite interest rates for a 30-year mortgage. (See sidebar: “Inside Interest Only.”) The resulting index shows what percentage of a median home (the one for which half the sale prices were above and half below) a family can afford with the median income. A low number means that home owners can’t afford the standard home or that they must pay much more of their income toward it. A high number means the average house is easily within reach.

Five of our 12 cities had affordability indexes below 100: San Francisco, New York, Los Angeles, Miami and Boston. Some of these cities–including Boston and Los Angeles–are slightly more affordable now than they were in 1980. But in nearly every metro area, affordability has declined in the past few years.

But it’s all relative. In Dallas, the median income can get you more than 200% of the median home. In Los Angeles, you can still get only 57%. In Philadelphia, the median home price more than tripled between 1980 and 2004, rising 220% from $57,570 to $184,190, which would suggest that houses would be harder to afford. But incomes rose, too, albeit not as dramatically, increasing 195% from just under $19,000 to more than $56,000.

In Miami, the affordability index hit a high of 124 in 1993, but now is down to just 75.
Robert J.
Shiller
Robert J. Shiller
, a Yale University economics professor whose book Irrational Exuberance predicted the dot-com bubble, pegs Miami as a “glamour city,” where people are buying because it’s glitzy and trendy, making the city more vulnerable to a bust. In March, Florida-based investment firm Raymond James & Associates said that 85% of condo sales in downtown Miami might be due to investment and speculation.

“Speculation changes the normal market,” says John H. Vogel, professor at the Tuck School of Business at Dartmouth College. “People are buying a half-million-dollar house not because they have the salaries to support it, but because they think next year it’s going to be worth $600,000.”

So does this mean we’re headed for a crash? That’s difficult to predict. In 2002, we dubbed the housing market a bubble and predicted its fall. Since then, home prices have gone up about 32%, according to the National Association of Realtors.

But that doesn’t mean a bust is not on the horizon–at least in some places. Greenspan used the phrase “irrational exuberance” to refer to tech stocks in 1996; it took another three years for the market to tank. And when it did, it hurt.